Regulation: US dealer bond inventory at nine-year lows
US corporate bond issuance down; Hopes for Volcker Rule rewording
Inventories of US corporate bonds with more than one year to maturity are just $45 billion – that compares with some $93 billion in February 2011 and $135 billion in February 2006 – according to the Federal Reserve Bank of New York’s monthly dealer updates.
|Inventory drops off a cliff|
|Mid-February inventory of corporate securities with more than one year to maturity held by US dealers|
|Source: Federal Reserve Bank of New York|
The low levels of inventory are not expected to tick up. Brad Rogoff, head of credit strategy research at Barclays Capital in New York, says: "There was a question of whether the downward trend in inventory was cyclical or secular, but now we know it is the latter. After each of the sell-offs over the last two summers, we have seen the inventory drop further. Even in market rallies there has been no bounce." The decrease in inventory is in large part due to the pending Volcker rule that prevents broker dealers from taking part in proprietary trading, therefore reducing the amount of bonds that a dealer can hold. Basle III’s requirement for increased risk-weighting of debt is also discouraging dealers from holding certain bonds.
Ramifications for issuers
The lower inventory, and therefore less liquidity, in the US corporate bond market has ramifications for issuers, and the impact is evidenced in issuance volumes.
According to Dealogic, $138 billion had been issued in US investment-grade debt this year as of February 15 – almost $20 billion less than the same time-frame last year coming from 120 fewer issues.
As the Volcker Rule approaches being finalized, concern about the impact on corporate borrowers is growing. Small and medium-sized companies reliant on the bond markets to raise capital are facing higher premiums.
Brad Rogoff, Barclays Capital
Rogoff says: "The coupons that smaller, less-liquid companies are being forced to pay are increasing. Even if the triple-C bonds are participating in a market rally, their coupons in primary market deals have to be higher than before." At some point, the higher coupons might prevent some issuers from accessing the market, he adds.
Even for larger corporates, there is a cost. Decreased liquidity is making their bond yield movements more volatile. The higher cost to US corporates of financing could mean that a US economic recovery will be slowed down.
An Oliver Wyman study commissioned by the Securities Industry and Financial Markets Association estimates that corporate issuers might incur $12 billion to $43 billion in incremental borrowing costs as a result of the rule.
Mutual fund managers are also critical of the rule in its current format. They are required to provide daily liquidity in their bond funds, and, with less liquidity in the system, they are having to pay more for liquid holdings and rethink their investments in smaller, less-liquid bonds.
In the Investment Company Institute’s (ICI) 41-page letter to the SEC, it states that less liquidity has serious implications for registered funds. "It leads to wider bid-ask spreads, increased market fragmentation and ultimately higher costs for fund shareholders," it states.
The letter also points out that the Volcker Rule as it stands will limit the investment opportunities for funds as the "narrow exemption in the proposed rule for trading outside of the United States could significantly limit US registered funds’ access to non-US counterparties".
Attack and defence
The window for opinion letters from market participants regarding the proposed rule closed last month. The SEC received almost 15,000 public comments, and regulators have until July to complete the rule.
Barry Zubrow, chief risk officer at JPMorgan, wrote in a 67-page letter that the proposed rule would have "serious, adverse effects on our ability to manage our risks and address the needs of our clients, and on market liquidity and economic growth".
Paul Volcker submitted a five-page letter to the SEC defending his own rule. "My short answer to each of these objections is: ‘Not so’," he wrote. Proprietary trading, Volcker said, is "at odds with the basic objectives of financial reforms: to reduce excessive risk, to reinforce prudential supervision and to assure the continuity of essential services".
Dealers say there is hope the language in the Volcker Rule will be changed to stop inventory falling further. It is unclear, for example, what constitutes proprietary trading and what does not. If a dealer holds a bond for a year to make money, then that would be deemed to be proprietary trading, but holding a bond for a week to meet client demand is allowed by the rule.
"That’s saying that dealers have to accurately predict client demand to own bonds," says the head of one US broker dealer. "If dealers could do that, they would be making money every day. That does not make sense and the wording has to change to allow greater flexibility."
One head of bond trading at a US bank says the rule might work for the equity market but it does not translate into the corporate bond market: "Bond liquidity is based on principal-type trading, not agency. They don’t trade on screens. Having a rule for both equities and bonds that is the same is not sensible."
More derivative use
Mary Cove, managing director at Cambridge Associates, says the decreased liquidity is likely to encourage increased use of derivatives. "For example, to reduce cash drag, you see S&P index fund managers taking a derivatives position in an S&P derivative to make sure the cash is equitized.
"In the bond market, spreads are likely to widen due to the reduced liquidity, so managers may want to reduce the amount of transactions they make. One way of doing that will be to use derivatives instead to get exposure if it is not hindered by legal requirements."
Indeed, some advocates of the Volcker Rule say the market will come up with new ways to fill the drop in liquidity – be that by banks spinning off their proprietary trading units or other entities setting up to fill the gap.
While new entrants would reduce systemic risk from large financial institutions failing as a result of their prop desks, it does, however, increase the shadow banking industry. That means the activity has simply been moved to "less-transparent and less-regulated financial institutions", says the ICI.